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SEC Gearing Up for New Rules

Soft money, money laundering, 12b-1, conflicts of interest, and risk-based exams are just a few items on thisyear's to-do list

Get ready. The Securities and Exchange Commission is expected to issue a new rule this year on soft dollars as well as amendments to Form ADV Part II. Plus, the securities regulator has started a new risk-based exam cycle for advisors--called "risk targeted sweeps"-- and has implemented a new exam hotline that advisors can call if they want to rant about an exam. Advisors, too, can expect a money-laundering rule from the U.S. Treasury Department this year.

In March, the SEC decided against requiring a mandatory 2% redemption fee on mutual fund shares that are sold within five days of purchase. The Commission voted instead for a voluntary seven-day redemption fee. This has prompted many investment professionals to question why the SEC even bothered to issue a rule, since mutual fund boards could already voluntarily set a redemption fee to thwart market timers.

Greg Knopf, managing director of Highmark Funds in San Francisco, is one such fund manager who's still scratching his head. "I think the SEC could have easily done nothing and let funds act individually," he says. In December, his firm implemented a 2% redemption fee for a period of five days. "Whether we will change that to seven days" is uncertain, he says. "You're going to thwart market timing with five days just as you would with seven."

Jeffrey Ptak, a senior mutual fund analyst at Morningstar, says that "it's disappointing that the SEC wasn't able to find its way to mandating this" redemption fee rule. A 2% fee on redemptions made within five days is "hardly something that would crimp the style of a lot of shareholders," he says. Further, in "the original proposal the SEC had carved out exceptions for shareholders with smaller [withdrawal] amounts, and also people that had to withdraw in certain hardship situations."

The SEC has also decided not to completely do away with soft dollars, a measure the Commission was contemplating last year. "We are not banning soft dollars," Nancy Morris, an attorney in the SEC's Division of Investment Management told advisors at a compliance conference in Washington held by the Investment Counsel Association of America (ICAA) and IA Week in early March. "The SEC is looking at recordkeeping, and what information brokers and advisors must keep," she said. Everyone expected the SEC to put out a rule on soft dollars early in 2005, but we'll have to wait until later this year.

Robert Haggerty, a senior analyst at TowerGroup, a financial services research firm in Needham, Massachusetts, says the SEC is "doing the right thing" by not banning soft dollars and focusing on transparency and disclosure. "The real issue with soft dollars is trying to achieve best execution," he says. "It's hard to imagine investment managers are really achieving best execution when agreements have been made to trade a certain amount for a broker because the [broker] provided [the manager] with some research." He adds that investment managers should be disclosing "who they are doing business with, and whether it's soft or hard dollars, combined with [whether they are] achieving best execution of trades."

Morris with SEC said the regulator was not moving toward requiring brokers and money managers to unbundle commissions--a practice that's now used in the UK. Rather, the SEC wants "people to know where the money is being spent," Morris said. But John Meserve, president of Westminster Research, a subsidiary of Bank of New York, argues that if "recordkeeping and disclosure requires Goldman Sachs to tell Putnam what's in a commission dollar, you are effectively unbundling."

All Research the Same

At Westminster, a third-party research firm, clients get a statement that tells them how much money they've paid for research and how much for execution, so clients see "what's in the commission," Meserve says. But the real issue with soft dollars according to SEC Chairman William Donaldson, he says, is what types of information does "a proprietary firm have to give to its fund manager clients." Thomas Lemke, a partner with the law firm Morgan Lewis & Bockius in Washington, told ICAA conference attendees that the SEC thinks proprietary and third-party research should be treated the same. Donaldson told Congress last year that independent third-party research and proprietary research "need to be treated alike so that they are on a level playing field," Meserve adds.

Indeed, Donaldson confirmed those opinions in testimony before the Senate Banking Committee last month. He said SEC staff is examining the definition of "research" as used in Section 28(e) of the Securities Exchange Act of 1934. "Soft-dollar arrangements present many of the same concerns irrespective of whether research is provided on a proprietary basis, or by an independent research provider," he told Congress. Donaldson said he expects SEC staff to accord similar treatment to research that is provided on a proprietary basis and to research by independent providers.

What's going on now, Meserve says, is that the "money managers that have been in the regulatory spotlight have said, 'Let's pay cash for third-party research'" instead of using soft dollars. A lot of fund companies have "been paralyzed as to what to do [now that] some of the larger fund companies are suggesting paying cash for these services," he says. "They are looking for clarity from the SEC."

Even if the SEC doesn't eliminate third-party research, said Lemke, "some clients are telling their firms to get out of it." Indeed, due to a fear that third-party research will be abolished, third-party research is starting to resemble proprietary research, he said. "Third-party researchers are forming as broker/dealers and providing introductory broker services," Lemke told conference attendees.

Also on the horizon, Donaldson told Congress, are some changes to 12b-1 fees. Because the mutual fund industry has evolved so much since 12b-1 fees were created 20 years ago, he said, "the idea of using 12b-1 fees as a substitute for a sales load--which in many cases they've come to be--is different than the use of 12b-1 fees for advertising and marketing purposes, which was envisioned when the rule was adopted."

A New Part II

As for Form ADV Part II, Jennifer Sawin, a senior advisor in the SEC's Division of Investment Management, told conference attendees that amendments to Part II are "very close" to being ready. "A lot of the topics are the same" under the new Part II, Sawin said, but advisors will now be required to disclose, in narrative form, conflicts of interest that could arise. Robert Bagnall, a partner with the law firm Wilmer Cutler Pickering Hale & Dorr in Washington, told attendees that the areas that will be the most "tricky" to disclose when complying with Part II include business practices that involve conflicts of interest such as soft dollars, participation in client transactions, and cross transactions.

Part II will be administered electronically on the Investment Adviser Registration Depository (IARD) system, said Sawin, and advisors will be able to attach Part II much like they would an email attachment. Advisors won't be required to send a copy of Part II to the SEC, she said, but they will need to keep a copy for their files, and "it should be updated." Once Part II is released, Sawin said, advisors would have a year to comply.

Exams and Complaints

The SEC's new risk-based exam schedule is underway, and is officially being dubbed "risk targeted sweeps," John Walsh, chief counsel in the SEC's Office of Compliance Inspections and Examinations, told conference goers. Walsh said the SEC really doesn't have an exam cycle anymore. "We could be in to see you more frequently than five years, or not." It depends on a firm's level of risky practices, such as the integrity of a firm's fiduciary advice, its performance advertising, and valuation practices, among other things, Walsh said. Moreover, advisors are now given a risk rating by the SEC, he said. The SEC is evaluating the "riskiest" firms on a regular basis, Walsh said, and is also conducting randomly selected advisory firms to examine "to get a sense of what's going on the industry."

If advisors have a complaint about a recent exam, they can now call the SEC's exam hotline and talk to senior attorneys in the Office of Compliance Inspections and Examinations Office of Chief Counsel. Lori Richards, director of OCIE, told conference attendees that while she expects few calls, she wants "to respond to any complaints with the same speed and vigor that we expect from securities firms when they receive complaints from their customers." Advisors can call the hotline at (202) 551-EXAM (3926), or send an e-mail to ExamHotline@sec.gov.

U.S. Treasury money-laundering regulations for SEC-registered advisors are expected in the second half of this year, according to David Tittsworth, ICAA's Executive Director. The proposal that RIAs have their own set of money-laundering rules came out in May 2003. Treasury is arguing that advisors should be subject to anti-money-laundering rules because advisors are in a know-your-customer position.

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